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Finding Lynch's 10-Baggers

There's a method to finding tomorrow's home runs.

Peter Lynch is recognized by investors the world over. More than 1 million read his book One Up on Wall Street -- at least, that many bought it. Sadly, many seem either to have disregarded or forgotten the book's tenets for finding great investments.

And that's a shame. After all, the greatest of these investments -- in Lynch's words, the "10- to 40-baggers. . . even 200-baggers" -- can rise 10 to 200 times in value.

I haven't forgotten. A "student" of Peter Lynch for years, I don't deny that what I've learned has influenced the way I invest. Nor that, when we conceived of our Motley Fool Hidden Gems newsletter service and online community, digging up just a few of these "10- to 40-baggers" was very much on our minds.

It might be worthwhile, then, to take a look at six of Peter Lynch's primary principles, all of which are core components to our Hidden Gems investing approach. I strongly encourage you to consider them when building or fine-tuning your own stock portfolio.

1. Small companiesLynch loves emerging businesses with strong balance sheets, and so do I. His extraordinary returns in La Quinta Inns came at a time when the company was young and small, traded at a discount to estimated future growth, and sported a healthy balance sheet. Why did Lynch veer away from such dominant franchises as Starwood Hotels & Resorts(NYSE:HOT) and Cendant(NYSE:CD) in favor of the promising upstart? Lynch writes, "Big companies don't have big stock moves... you'll get your biggest moves in smaller companies."

Couldn't have said it better myself. When searching for hidden gems, I focus explicitly on strong, well-run companies capitalized under $2 billion.

2. Fast growersAmong Lynch's favorites are companies whose sales and earnings are expanding 20% to 30% per year. The classic Lynch play over the last decade might be Starbucks, which has consistently grown sales and earnings at superior rates. The company has a sterling balance sheet and generates substantial earnings by selling an addictive product, repurchased every day at a premium by its loyal customers.

The real trick is to find fast growers such as Starbucks or America Online (now part of Time Warner(NYSE:TWX)) in their early stages. At the same time, don't shy away from a slower-growth business selling at a truly great price. Hidden gems can take either form.

3. Dull names, dull products, dead industryYou might not think this of the world's greatest -- and arguably, most famous -- mutual fund manager, but Lynch absolutely loved dreary, colorless businesses in stagnant or declining industries. A company such as Masco Corporation, which developed the single-handle ball faucet (yawn), rose more than 1,300 times in value from 1958 to 1987.

And if Lynch could find that kind of business with a ridiculous name, such as Pep Boys, all the better. No self-respecting Wall Street broker could recommend such an absurdly named unknown to his key clients. And that left the greatest money managers an opportunity to scoop up a truly solid business at a deep discount.

4. Wall Street doesn't carePeter Lynch's dream stock at Fidelity Magellan was one that hadn't yet attracted any attention from Wall Street. No analysts covered the business, which was less than 20% institutionally owned. None of the big money cared. Toys "R" Us, though it might not be so great an investment today, after being spun out from its bankrupt parent, Interstate Department Stores, went on in relative obscurity to rise more than 55 times in value.

And Lynch is effusive in explaining the wonderful returns from funeral and cemetery business Service Corporation(NYSE:SRV), which had no analyst coverage. He suggests investors compare that to dozens of analysts who normally cover Qualcomm(NASDAQ:QCOM) or Exxon(NYSE:XOM).

The point is clear: Small, underfollowed companies present the greatest opportunities to long-term investors.

5. Insider buying and share buybacksLynch loves companies whose boards of directors and executive teams put their money where their mouths are. A combination of insider buying and aggressive share buybacks really piqued his interest. He would have given a close look to a tiny company such as Spar Group(NASDAQ:SGRP), which has featured persistent insider buying, but also a Moody's, which methodically buys back its shares on the open market.

"Buying back shares," Lynch writes, "is the simplest, best way a company can reward its investors." Bingo.

6. DiversificationFinally, don't forget that Peter Lynch typically owned more than 1,000 stocks at Fidelity Magellan. He embraced diversification and focused his attention on upstart businesses with excellent earnings, sound balance sheets, and little to no Wall Street coverage. Lynch admits that, going in, he never knew which of his investments would rise five or 10 times in value. But the greatest of his investments took three to four years to reward him with smashing returns.

Personally, I anticipate an average holding period of three years, with the greatest of the group being held for a decade or more. I believe you can and should run a broad, diversified portfolio of stocks, if you have the time and the team to do so -- like we do here at the Fool and within our Hidden Gems community.

Finding the next hidden gemPeter Lynch created loads of millionaires with his Fidelity Magellan Fund -- investors who went on to live comfortably, send their kids to college, and give generously to deserving charities.

You might be surprised to hear that Lynch thinks you can succeed at stock investing without giving your whole life over to financial-statement analysis. He's outlined a method whereby the total research time to find a stock "equals a couple hours." And he doesn't think you need to check back on your stocks but once a quarter. Doing more than that might lead to needless hyperactive trading that wears down your portfolio with transaction costs and taxes.

Hidden Gems practices each and every one of these Lynchian precepts. If this is how you like to invest, I guarantee you'll love our newsletter service. Try it free for 30 days and, if you don't absolutely love it, you can cancel without paying a tin-lizzy nickel.

The next 10-bagger is out there. Good luck finding it!

Of the companies mentioned in this article, Tom Gardnerowns shares of Time Warner. The Motley Fool is investors writingfor investors.